Is ECB really enemy of the euro? More on Bagehot's rule

ECB did not follow Bagehot's rule

Martin Sandbu criticizes ECB for its course of action in the weeks before voting in Greece (Financial Times, July 6):

Recall that the closure of Greece's banks was caused by the ECB's decision to do the opposite of what Walter Bagehot taught, which that to steam a bank run, the central bank should lend against collateral that, but for the crisis, is solid. In Grece fearful people have wanted cash, but the banks have little cash left. The normal course of action would be for the banks to get cash from the central bank, pledging their investments as security for the loan. But after Athens declared a referendum, the ECB said no further such loans should (for now) be given.

Martin's article has a plenty of interesting and valuable comments. However, in order to see bigger picture it makes sense to examine Bagehot's rule a little bit deeper.

What is Bagehot's rule?

Walter Bagehot suggested the rule also known as Bagehot's dictum which is widely accepted by central banks till now [1, p. 198-199]:

  • In time of panic it must advance freely and vigorously to the public out of the reserve 1
  • These loans shall be made at a very high rate of interest
  • These advances should be made on all good banking securities, and as largely as the public asks for them

This rule is often summarized as: To avert panic, central banks should lend early and freely (i.e. without limit), to solvent firms, against good collateral, and at high rates.

Bagehot's rule - when to apply?

It's important to note that Bagehot's rule is not for daily operations of the central bank. It is a policy of the central bank to stop panic. And Bagehot did not offer it as a silver bullet [1, ch. VII, p. 201]:

This policy may not save the Bank; but if it do not, nothing will save it.

Bagehot offered an extensive argumentation to defend this rule which in his time was not obvious not only for the public but even for the Bank administration.

In particular, he explains [1, ch. VII, p. 199-200]:

  • The way to cause alarm is to refuse (to make advances - V.R.) someone who has good security to offer. The news of this will spread in an instant through all the Money Market at a moment of terror.
  • Unsound people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected.

As you see the ultimate goal for Bagehot is to stop spreading of panic.

ECB and Greece in 2015

Why ECB was able to refuse to make advances to Greek banks? Just because there was no panic in Europe. And there was no risk of it. The goal of Bagehot's rule is to prevent panic. But the panic was not European. It was local (Greek-only) panic.

If the situation was opposite - e.g., panic could spread from Greece to other European countries then ECB had no choice but to follow Bagehots' rule. As it was doing before!

It does not mean that ECB selected right course of actions. I agree with Martin that ECB did not act as a central bank for Greece. But it was able to choose this path. Just because there was no market pressure.

Bagehot suggested his rule in the times when Bank of England was a private company. Bank followed it not because of its public duties or legislation or any moral considerations. It was following this rule because it was for the benefit of the bank itself. I think this is the point which shall not be missed when we are analyzing ECB behavior.

Interesting question arises - is ECB acting as a central bank of EU as a whole or as a central bank of each individual country? It looks like ECB acts as a central bank for the whole EU. And it explains why it did what it did with Greece.

Another interesting question is - how deep EU economies are integrated? I doubt if the panic of Greek caliber starts in California, Fed is forced to execute Bagehot's rule in order to stop the panic for spreading through US. And it was not the case with one of the European countries - Greece.

Bibliography

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  1. "It" refers to the Bank of England which was acting as a central bank in Bagehot's time. 

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